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Wednesday, May 23, 2012

Why a Greek Exit Could Be Much Worse than Expected (By Time)

Below is a very interesting article from Time about the possible crisis that could happen if the Greece exits the Euro. Have a read. My personal take, it won't happen. Wall Street will not allow it to happen and they will lobby the US Congress to supplement the European Central Bank support measures.





At the G-8 meeting at Camp David last weekend, lip service was paid to keeping Greece in the euro zone. But economists who are watching the continuing financial crisis in Europe are increasingly coming to two conclusions: Greece is likely to abandon the common euro currency now used by 17 European countries. And when it does, perhaps within a matter of months, there will be a damaging domino effect throughout much of Europe. Not all domino effects are created equal, however. And there are two possible consequences if Greece leaves the euro zone that few observers seem to have considered.

The scenario everyone recognizes is based on Greece’s reviving its traditional currency, the drachma. In this case, salaries and prices within Greece would be converted from euros to drachmas, and the drachma would be allowed to depreciate to make the Greek economy more competitive. The problem comes with debts that are denominated in euros, especially if the lenders are outside of Greece. These lenders would naturally resist being repaid with less valuable drachmas. However, if Greek borrowers have to repay the loans with euros, the debt would become more expensive for them to pay off after the drachma is devalued.

The most likely domino effect, therefore — and the one most widely expected — is that debts to non-Greek creditors would be compromised after Greece switches to the drachma. There would be lawsuits over which currency to use, or borrowers would default on the loans, or lenders would be forced to accept reductions in the amount of the loans that have to be repaid, in order to avoid outright defaults. Whichever outcome occurs, the lenders lose money. Just as in the U.S. mortgage-lending crisis, once some banks lose enough money to become troubled, the contamination spreads to other banks, because they all lend to one another.

That’s not a pleasant prospect, but at least it’s fairly clear how to manage it. Greece leaves the euro zone, and its economy suffers for a couple of years but then stabilizes. With Greece gone, the rest of the euro zone could be propped up more easily. Many major banks take big losses on Greek debt. Some fail, some are taken over by stronger banks. Governments have to bail out the biggest losers. And the banking system is made sound again, although at considerable expense to taxpayers in many countries.

But what if Greece’s exit from the euro zone causes other kinds of domino effects that don’t have obvious precedents? The fallout could be a lot harder to control. As I see it, there are two scenarios that aren’t getting the attention they should.

Derivatives could set off a global chain reaction. Most people have heard of the complex, “synthetic” financial securities known as derivatives, which Warren Buffett famously referred to as “financial weapons of mass destruction.” In the case of bonds, these are known as credit derivatives. They include all sorts of loans secured by bonds as well as incredibly complicated vehicles that amount to insurance policies if the bonds default. No one really knows how much of this stuff is sloshing around the international financial system, but the total value for all types of bonds was estimated at more than $50 trillion in 2008 and has continued to grow rapidly since then. Trouble is, if the bonds underlying these derivatives become questionable, all the derivatives become uncertain too, even if they add up to far more than the value of the bonds themselves. Moreover, some of the synthetic investments based on Greek bonds could be governed by Greek law, some by British law (if anything originated in London) and some by U.S. law (if Wall Street was involved).

What if one legal system accepts the conversion of euro loans into drachmas and another doesn’t? Everything could be thrown into the courts for months. Even worse, if synthetic investments secured by Greek bonds become untrustworthy, why would anyone trust similarly complex investments involving Spanish bonds or Italian bonds?

The result of a meltdown in the world of derivative investments could cause far more chaos than simple bond defaults, not least because it would be almost impossible to figure out who owed how much to whom.

Greece recovers quickly, and all the other troubled countries want out of the euro zone too. At the opposite end of the spectrum is the possibility that Greece abandons the euro and bounces back surprisingly fast. Paradoxically, that could cause another sort of disaster. Both Argentina and Iceland suffered currency collapses, but after a horrible year or two, they each rebounded and were better off than if they had fought to save a failing currency. Analysts point out that both countries were big exporters of grain, meat or fish and that sales boomed after currencies were devalued. But Greece, in its own way, could profit from a similar recovery — a rebound in tourism. A 30% drop in the exchange rate might make a vacation in Greece the best deal in years.

So why would that be bad? Think of what it would mean for the other countries in the euro zone. How could the Italian government convince its people of the need for higher taxes or the Spanish government explain soaring unemployment if Greece were obviously better off outside the euro zone? Result: the entire European Union might unravel, with financial consequences many times greater than those resulting from Greece alone.

I’m not predicting an extreme, doomsday scenario as the most likely outcome of a Greek exit. But it is important to realize just how unpredictable this situation is. In my own stock portfolio, I eliminated all the banks a long time ago and have largely stuck with financially strong companies that deal in essential goods, such as oil and gas, consumer staples and pharmaceuticals. The euro created a financial entity comparable in scale to the U.S., and if it gets into serious trouble, the financial effects could be world shaking.

Read more: http://business.time.com/2012/05/22/euro-crisis-why-a-greek-exit-could-be-much-worse-than-expected/?xid=newsletter-daily#ixzz1veZ5l6iC

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